Why is there a grey market for IPOs in India?

As SEBI cracks down on the business of P-Notes and the tax department follows up on the use of cash for generating unaccounted incomes, it comes as a surprise that the grey market for shares thrives unfettered. It is fairly common for major newspapers to quote the premium offered on the grey market following any Initial Public Offer (IPO). Some important questions arise in this context – why do grey markets exist at all when there is a fairly well established method of price discovery in India, have there been changes in the rules of allotment that may have triggered such a response and why the income tax department as well as SEBI should worry about the existence of this market.

The grey market for IPOs has existed in India for a while. It is an active market with volumes that are fairly comparable to the official market. India has a booming IPO market where the returns earned on the day of listing can be more than double of the issue price. Krishnamurti et al. (2011) estimate that on the day of listing (in 2007-08), the return earned was 93 per cent. In another estimate, it has been found that 68 per cent of the IPOs listed at prices that assured a return to an investor higher than the returns earned over a year. With such returns, the grey market fits in like a missing market that allows those bidding in an IPO to lock in the gains prior to the listing. The existence of the grey market therefore is predicated on the under-pricing of IPOs. The issue of under-pricing of IPOs has been treated at length by studies. As early as in the 1970s, Logue (1973) and Ibbotson (1975) raised this issue and the same has been dealt in detail in the context of different countries by subsequent studies such as Ritter and Welch (2002), Marisetty and Subrahmanyam (2009) and Hassan et al. (2010). Given that there is substantial evidence to support the under-pricing of IPOs, the brisk business in the grey market can be attributed to some extent to this under-pricing.

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In trying to find why the issues are under-priced it is found in studies for countries other than India (Loughran and Ritter, 2002; Reuter, 2006; Nimalendran, Ritter and Zhang, 2007; and Goldstein, Irvine and Puckett, 2011) that “self-interested underwriters have strong incentives to bias the price down so that they can allocate under-priced shares to their favoured clients in exchange for side payments”. Such self-interest can be realised if the rules of allotment lack transparency. While in the US, the allocation of shares rests with the underwriting investment bank, which has been said to breed corruption in allocation (Nimalendran, Ritter, and Zhang, 2007; Liu and Ritter, 2010). In India, SEBI prescribed disclosure of allotments made to anchor investors. Further, in 2012, SEBI changed the rules relating to the allotment of shares in the category of retail investors. For over-subscribed IPOs where the number of investors exceeded the designated lot of shares, the allotment process was to follow a lottery system. It is expected that the sunshine requirement makes the allotment to the anchor investors a relatively transparent process. As for the retail investors, given the discontent with the lottery based allotment to retail investors in over-subscribed issues, the allotment process creates an incentive to sell the application through an off-market trade for an assured return. Therefore, the existing functioning of the markets and the rules in some way work as useful aides to the grey market.

The reasons for the success of grey market can be attributed to the flaws in the existing rules and the process. The pricing and the process of allotment make the sale of application in the grey market lucrative. The functioning of grey market rests on the use of cash. The fact that all settlements are carried out through and yet has not attracted any scrutiny is unsettling. Though the capital gains tax are paid in full, the fact is that it is borne by the retail investor, thus the broker offering the return on grey market ends up paying nothing. Therefore, even though on a gross basis there is no evasion, the broker is technically evading tax and is perpetuating the generation of unaccounted incomes. The fact that the broker is willing to pay a fixed return knowing that the price fixed in the grey market may not be realised is a reflection of two things – deep pockets and higher certainty of returns thereby making the case for controlling such activities.

Is so called grey market really grey? Here things are just plain black and white given the underpricing of IPOs at the first place. Actually the so called formal market is grey where investors do not have a clue on what will happen on listing.

The functioning of these markets in Mumbai and parts of Gujarat is quite something.